Generally, under Internal Revenue Code (IRC) § 61(a)(12) cancelation of debt (COD) is taxable as ordinary income. However, under certain circumstances such income can be excluded under IRC § 108 where, the COD occurs as a result of a discharge in a title 11 bankruptcy case (IRC § 108(a)(1)(A)), where the discharge occurs when the taxpayer is insolvent (IRC § 108(a)(1)(B)), where the indebtedness discharged is qualified farm indebtedness (IRC § 108(a)(1)(C)), where the indebtedness discharged is qualified real property business indebtedness (IRC § 108(a)(1)(D)), or where the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2013 (IRC § 108(a)(1)(E), the “2007 Mortgage Relief Act”).
There is no free lunch when it comes to exclusion of the COD. The “price” for exclusion occurs under IRC § 108(b) which requires that the taxpayer’s tax attributes be reduced by the amount of the income excluded. In many cases, IRC § 108 only defers payment of the tax on the COD income. The method by which the tax attributes are reduced differs under each subsection of IRC §108(a)(1). Only the exclusion of COD income resulting from a bankruptcy discharge will be discussed.
In determining the amount of COD income, IRC § 108(e)(2) provides that “[n]o income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction.” For example where there is a foreclosure the amount of debt forgiveness does not include accrued but unpaid interest since the taxpayer could have deducted the interest if paid. Likewise where a landlord forgives unpaid rent owed by a business debtor, this discharge would not be COD income since the taxpayer could have deducted the rent as a business expense if paid.
Once the amount of COD income is determined, IRC § 108(b)(2) requires the taxpayer to reduce tax attributes in the following order:
(A) Net operating losses;
(B) General business tax credits (at 33 1/3% of the income excluded);
(C) Minimum tax credits (at 33 1/3% of the income excluded);
(D) Capital losses;
(E) Property basis;
(F) Passive activity loss and credits (at 33 1/3% of the income excluded for the credits); and
(G) Foreign tax credits (at 33 1/3% of the income excluded) .
The reduction in basis under IRC § 108(b)(2)(E) in a Title 11 case is governed under the provisions of IRC § 1017(b)(2) which limits the reduction to the excess of the “(A) aggregate of the bases of the property held by the taxpayer immediately after the discharge, over (B) the aggregate of the liabilities of the taxpayer immediately after the discharge.” Treasury Regulation 1.1017-1(b)(3) provides that aggregate liabilities must be reduced by the amount of any cash on hand. Treasury regulation 1.1017-1(a) prescribes the order in which the bases in the taxpayer’s property is reduced. Property where the tax attributes are reduced in the above order, is not limited to depreciable property but consists of all the property of the taxpayer.
Alternatively, the taxpayer can elect under IRC § 108(b)(5) to first apply any portion of the required reduction to the taxpayer’s depreciable property before any other tax attributes are reduced. Under this election the reduction in basis is not limited to the excess of basis over liabilities but can reduce the basis to zero (IRC § 108(b)(5)(B)). Property under this election is limited to depreciable property of the taxpayer (IRC § 1017(b)(3)).
If the excluded COD income exceeds the sum of the taxpayer’s tax attributes, the excess is permanently excluded from the taxpayer’s gross income (Treasury Regulation 1.108-7(a)(2)).
The required adjustment to basis has future adverse consequences. Upon the later sale or taxable disposition at a gain of property whose basis has been reduced the portion of the gain attributable to the basis reduction is taxable as ordinary income (IRC § 1017(d)).
The reduction in tax attributes occurs following the determination of the tax for the taxable year of the discharge and any reduction in basis occurs on the first day of the first taxable year following the year in which the discharge takes place. This allows for planning opportunities especially in nonbankruptcy cases. Where the taxpayer is able to dispose of properties subject to the basis reduction in the same year as the discharge occurs, no basis reduction takes place with respect to those properties.
The reduction in tax attributes is reported on IRS Form 982 which is filed with the federal income tax return for the year in which the discharge of indebtedness occurs.
Finally, and most importantly, in bankruptcy cases only, where COD income is excluded from gross income, there is no basis reduction to any property which is claimed as exempt under Bankruptcy Code § 522 (IRC § 1017(c)(1)).
The following examples illustrate the operation in a bankruptcy context of IRC §§ 108 and 1017:
Dan files Chapter 7 bankruptcy on June 1, 2010 and has the following assets, liabilities and tax attributes:
- Home worth $250,000 with a first mortgage of $300,000, a second mortgage of $200,000 and a basis of $400,000. Both mortgages are recourse. Client has lived in the home for the last 3 years.
- Rental property worth $525,000 with a recourse first mortgage of $500,000 and a basis of $400,000.
- Miscellaneous other assets all within the allowable bankruptcy exemptions.
- No cash on hand.
- Unsecured credit card debt of $100,000.
- A NOL carryforward of $75,000 from a failed business.
- A passive activity loss carryforward of $35,000 from the rental property.
Dan schedules as exempt on bankruptcy schedule C his home and the miscellaneous other assets. The Bankruptcy Trustee does not administer any assets. Although there is some equity in the rental property the Trustee decides not to administer it calculating that nothing would be available to pay creditors after payment of real estate commissions and costs of sale. Dan receives his bankruptcy discharge on October 1, 2010.
Dan realizes gross employment income for 2010 of $50,000. Assume that the rental property breaks even for 2010, that Dan has no other income and that he does not itemize deductions.
As a result of the bankruptcy Dan realizes $350,000 of discharge of indebtedness income for 2010 ($100,000 in credit cards COD plus the excess of debt over FMV of home). Dan first determines his tax for 2010 before reducing tax attributes (IRC § 108(b)(4)(A)). Dan will apply $50,000 of his NOL carryforward to offset his taxable income for 2010.
If Dan does not elect to first apply the discharge of indebtedness income against his depreciable property, the $350,000 of discharge of indebtedness income will first reduce his remaining NOL of $25,000 to zero. There will be no reduction in basis for Dan’s home as it was claimed as an exempt asset in his bankruptcy schedules. There will be no reduction in basis for Dan’s rental property as its liabilities exceed its basis. There will be no reduction in basis of Dan’s other property (e.g. car, furniture, jewelry, etc.) as he has claimed those assets as exempt in schedule C. The discharge of indebtedness income will next reduce Dan’s passive loss carryforward to zero and the remaining $290,000 will forever escape taxation.
If Dan were to elect to first apply some or a portion of the discharge of indebtedness against his depreciable property, he could reduce his basis in the rental by the full $350,000 of discharge of indebtedness income from $400,000 to $50,000 (there is no limitation under this election other than Dan can only reduce the basis of depreciable property and not below zero). In this case he would retain both this NOL carryforward and the passive activity loss carryforward. The $25,000 NOL remaining after netting against Dan’s 2010 income would carryforward to future years, his passive loss carryforward would continue to be available, but he would face a much larger potential gain from a future sale of the rental with the first $350,000 taxable as ordinary income. Making this election would not seem to make sense unless Dan planned to hold the property for a very long time and calculated that the retention of the tax attributes outweighed the additional future tax, or Dan had a very short life expectancy and expected to die owning the property which would step up the basis to fair market value upon death.
If under the same facts, the basis of the rental property were instead in excess of its liabilities the basis would be reduced to the amount of the liabilities since the rental property was not claimed as an exempt asset on Schedule C. This result could be avoided by including the rental property on schedule C as an exempt asset and would have the additional benefit of protecting the rents generated from the rental property during the pendency of the bankruptcy.
There are other tax provisions that should be considered which may affect the amount of COD income including the possibility that the reduction in the liability may be a purchase price adjustment (IRC § 108(e)(5)) or that the tax benefit rule (IRC § 111) may apply.
Although the above discussion primarily applies to discharge of indebtedness in a bankruptcy case (IRC § 108(a)(1)(A)), the rules are very similar where the COD income is excluded as a result of insolvency (IRC § 108(a)(1)(B)) with one very significant difference: The exception that the basis of property claimed as exempt in bankruptcy is not reduced does not apply where the exclusion is based upon insolvency.
Furthermore, where the discharge is in connection with qualified principal residence indebtedness ((IRC § 108(a)(1)(E)), only the basis of the residence is reduced (IRC § 108(h)(1)) although the taxpayer can elect under IRC § 108(a)(2)(C) to instead have the tax attributes adjusted under the insolvency provisions. The reduction in basis effectively turns the COD income into capital gain which is eligible for the $500,000/$250,000 exclusion under IRC §121.
In most cases, however, the COD stems from foreclosure by the lender and no basis reduction occurs since the residence is not owned by the taxpayer on January 1 of the following year.
The adjustments mandated under IRC §§ 108 and 1017 are very complex and can have significant consequences which should be analyzed and understood before a petition for bankruptcy is filed. The bankruptcy practitioner needs to be aware of these issues and should advise the client of the options and consequences. If the attorney does not have the necessary expertise he or she should advise the client to seek guidance from a tax professional before filing the bankruptcy petition.
Elliott Abrams is a Walnut Creek attorney specializing in tax, estate planning and bankruptcy matters. He is a sole practitioner and has been in practice in Contra Costa County for thirty years. www.eabramslaw.com
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